Friday, April 20, 2007

Our last installment went into some fair detail on the old-fashioned single-class pass-through MBS as practiced by Ginnie Mae and the GSEs. These securities always had a huge advantage: they’re cheap to produce and easy to understand. Back in the days when there wasn’t much about the underlying loans that was hard to understand—you had your basic fixed rate, your basic amortizing one-year ARM—you could master the cash-flow issues over lunch.

The big drawback of the pass-through was always its prepayment and duration problems. The actual dollar yield on a bond—or a mortgage—is a matter of how long you earn interest at a given rate. If the loan prepays much earlier than you expect, you get your principal back, but you must now reinvest it somewhere else, and loans generally prepay fast when prevailing market rates are lower, putting the refinance “in the money” for the borrower and forcing the prepaid investor to buy a new lower yield. When market rates rise, prepayments slow considerably, but this extension means an investor has funds sunk in a low-yielding bond when new ones yield much more. Some investors, of course, would want to be prepaid more quickly or more slowly than average, if they were using MBS to hedge some other investment risk or just needed very high liquidity. The trouble with the single-class pass-through is that it’s just too unpredictable.

The big innovation in the MBS world was the CMO (Collateralized Mortgage Obligation, not to be confused with the CDO, or Collateralized Debt Obligation, which we’ll get to later). A CMO is also often called a REMIC (Real Estate Mortgage Investment Conduit) since that is the legal structure on which most of them are built. REMICs were developed in the 1980s, and the advantage (or disadvantage) to an issuer or investor of owning part of a REMIC has a lot to do with tax treatment of certain kinds of investment income. That is a level of detail into which I will not get. Suffice it to say that most CMOs work like REMICs even if they aren't true REMICs, and that I prefer to use the term REMIC here to keep from getting lost in the CMO-CDO confusion weeds.

REMICs are very complex, and so we’re just going to skim here. The basic idea is that the cash-flow from an underlying pool of whole loans—even one or more underlying pass-through MBS—can be sliced up or “tranched” into separate securities with differing cash-flow characteristics and time-to-maturity horizons. The simplest approach is “sequential pay”: a structure of classes is set up, with each tier getting its scheduled pro-rata share of the pool interest, but the top tier getting all the scheduled (and all or most of the unscheduled) payments of principal, until that tranche or class is paid off. Then the next tier gets principal payments, and so on. This lets you take an underlying pass-through with an expected maturity of 25 years and turn it into one 2-5 year bond, one 5-7 year bond, one 7-10 year bond, and so on. It also creates a “yield curve” within the REMIC, as the shorter-maturity classes earn a lower rate of interest than the longer ones. This is true even if the underlying loans are all 30-year fixed rates.

Remember that individual loans are not assigned to tranches or classes; what is being “allocated” in a REMIC is the total cash flow of principal and interest from the aggregated underlying loans. The underlying loans can be “grouped” in certain ways—they can be already securitized into pass-throughs, and you can have a group of loans or MBS assigned to a set of classes or tranches, but legally the REMIC trust owns all the underlying loans, and all underlying loans are available to pay whatever any given tranche-holder is owed.

But even a sequential-pay structure allows some unpredictability in the repayment characteristics of each tier. So most REMICs improve on the simple sequence by further refining the cash flow characteristics of each tranche. There is the “stripped” tranche: an IO strip pays interest only (on a nominal balance) while the PO strip pays principal only (the investor buys that bond at a deep discount). There are PACs and TACs (Planned or Targeted Amortization Classes) which pay principal according to a schedule that may have nothing to do with the actual amortization of the underlying loans. There are floaters and inverse floaters—tranches that pay interest that increases with a rise in an underlying index or the inverse (the yield decreases when the index rises, making these hedge vehicles). There are “accrual bonds,” which pay no cash flow for the initial years of the REMIC (the “lockout period”), although they accrue interest during that period.

There are also several kinds of “support bonds,” which is a generic term for a tranche needed to do or get the opposite of what one of the above tranches does or gets. An amortization class, for instance, generally needs a corresponding support bond that will get excess or shortfall prepayments of principal “left over” from the principal allocation to the PAC or TAC. There is always, finally, a “residual” bond, at the bottom of the whole elaborate structure, that gets whatever is left. Residuals are nearly impossible to accurately value. With a true REMIC, the residual is generally held by the security trust. (Other kinds of structured MBS can generate a residual that can trade in the junk bond market.) The expected yield on any given class or tranche can vary widely, based on how close to expectations the actual payment and prepayment characteristics of the underlying loans end up being.

Having fun yet? For our purposes, here’s the point of caring about this: first, the original idea of the REMIC is to make mortgages a more attractive investment by controlling their repayment characteristics (just as single-class pass-through MBS made mortgages more attractive by controlling their credit risk). Over time, however, tails can start wagging dogs, and some of us are firmly convinced that mortgages started to become originated in products that would make a great REMIC. Imagine trying to do a simple pass-through MBS with interest-only hybrid ARMs combined with amortizing true ARMs. Or a pass-through with Option ARMs. Or HELOCs with an initial interest-only draw period followed by an amortizing repayment period. You need, basically, an exotic security in order to successfully originate exotic loans. Or, perhaps, you need increasingly exotic loans in order to feed the increasingly exotic securitization machine.

Second, the notion of a multi-class security is generally premised on the happy assumption of a bunch of different investors with different investment needs—fixed income, hedges, what have you—all of whom can come together, take the piece they want, and play “support bond” for each other, while the REMIC issuing trust happily takes the leftovers in the residual out of the kindness and generosity of its heart. What lurks beneath this premise—and will get crucial when we start talking about credit risk again—is that multi-class can introduce “class warfare.”

One thing you can say about the various part-owners of a big single-class pass-through is that they’re all in the same boat, since they’re all getting a pro-rata share of whatever is going on—fast prepayments, slow prepayments, high-coupon, low-coupon—in the underlying pool. In a multi-class REMIC, fast prepayments could be great for me and tough luck for you. Changes in the underlying interest rates on the loans could be tough for me and great for you. Theory says this is fine, because you are a rational informed agent, as am I, and we are buying whatever tranche we picked in order to hedge some risk we perceive, accurately, that we have. Besides the obvious retort to that—rational? bond investors?—there is the question of further, possibly quite unpleasant, effects on what the underlying mortgages have to look like to support all these harmoniously opposing classes.

In the big picture, we have a security structure that biases the mortgage market to refinances rather than modifications, and to loans that really have to refinance in practical terms (ARMs, IOs, balloons) over those that don’t (fixed rates). The structure readily accommodates exotic underlying mortgage loan structures, and hence removes “complexity risk” from the investor side (if not the mortgagor side). Very importantly, it removes investor aversion to early payoff risk—there’s always a “support bond” to profit from prepayments—eliminating a great deal of a mortgage originator’s disincentive to keep refinancing the same loan. Prepayment penalties get put on loans that are destined to prepay, given their toxic adjustments, which appears to be the only way the servicing for these securities can stay profitable.

Some people like to focus obsessively on mortgage broker and mortgage originator culpability for the mess we’re in, and certainly it never pays to underestimate that. But no broker or correspondent lender can originate an Option ARM with a shockingly high margin (the rate that kicks in when the “teaser” is gone) with no points unless some aggregator or REMIC conduit or other investor is paying 105 cents on the dollar for it. You can ask why anyone would pay so much premium for such a loan, especially given the likelihood that it will, you know, refi and pay off early.

The claim that premium pricing prevents rate predation—that the investor doesn’t “gain” by having a borrower pay an above-market rate because it pays too much premium for the loan—is a mite disingenuous in the context of structured securities. If you are buying whole loans for an investment portfolio, or for inclusion in a simple pass-through, that might make some sense. But if you are buying loans for a security in which someone will benefit from the fast prepayment of that loan—and someone else will benefit if it stays on the books—you may well be paying up for that loan precisely because it has the payment and prepayment characteristics you want, not in spite of them. There is always someone on the other side of a hedge trade. If there were no incentive for conduits to pay 105 for a loan, I can assure you that they wouldn’t pay it, or not for long. (Note to self: why did Grant Thornton just walk out on a couple of its auditees when the subject of secondary market pricing strategies came up? Are all these Wall Street-inspired conduits really paying a perfect price for this stuff? Hmmm.)

Remember the average 200 bps note rate spread in an old-fashioned GSE MBS? I just looked at a Fannie Mae 2007 issue REMIC, backed by Fannie Mae pass-throughs, with a note spread of 275 bps. A private-issue REMIC backed by non-GSE loans can easily have a total spread on the underlying loans of ten points or more, with an age-adjusted spread of 500 bps. (Remember that you must look at the age of the loans in a REMIC pool. The pass-through MBS loans are originated into a current (par) coupon, but a REMIC with flow or seasoned loans will have loans that were originated into different current coupons. A mortgage note rate is “above” or “below” market only in reference to what the par coupon was that day.) How much of the note spread in a private-issue REMIC is a question of credit quality we will deal with in the next installment. For now, just note that a GSE REMIC will have those famous fairly uniform and geographically diverse loans in its pools, so that duration—sensitivity to market rate changes—is affected by loan quality, not just note rate. By and large, GSE loans are refinanceable, whether or not they’re in the money for a refi.

A private-issue REMIC backed by jumbos, Alt-A, subprime, reperforming, scratch & dent, or a mixture thereof can require exceptionally complex prepayment calculations, as these loans may be less sensitive to market rate changes alone. In the “old days,” the cruddier the credit, the longer the loan stayed on the books, since there were fewer refi options. Then we went through this period where there was a REMIC for every loan, cruddy or not, and so sensitivity calculations all of a sudden got “counter-intuitive.” One definition of a “credit crunch” is a giant blow-up in durations. When the music stops, everybody has to take a chair and then sit there. If you didn’t get a chair, you default, the lender forecloses, and losses are dealt with somewhere. But if you did get a chair—and I continue to think that most prime borrowers will get one—you will, if it makes you feel any better, possibly be sticking it to some bondholders just by paying your loan back as agreed.

Whether all of these REMICs were structured carefully enough that they can fully survive a “crunch” is a good question. But it also depends on how REMICs deal with credit risk once we get away from the GSE ones and into the private-issues, where there is no GSE to guarantee the investor against principal loss. That part of the “musical chairs” game awaits the next installment.

In Memoriam: Doris "Tanta" Dungey

Tip Jar

Blogroll: I'm receiving 100s of requests to be on the blogroll and it is completely out of control.Right now the blogroll is frozen until further notice while I rethink the usefulness for the readers. Sorry.Thanks, CR